China, Fed rates: Key priorities for fund selectors

Financial markets have been under siege in recent weeks. Equity markets have fallen sharply, fixed income credit spreads have widened and currencies around the world have plunged. Behind the sharp increase in market volatility is a set of three headwinds that will take a while to push aside.

First, the Federal Reserve is slowly moving towards a decision to raise interest rates. A large majority of economists is forecasting such a move in September and more than 50% expect at least two rate hikes before the end of the year. Financial markets are far less convinced. The Fed Funds Futures markets is pricing in only about a 60% chance of even one rate hike this year. So, one headwind investors are facing is the uncertainty when the Fed will pull the trigger. We expect bond and equity markets can rally once that uncertainty is removed. Until then, markets are likely to remain choppy.

Second, the dramatic surge in Chinese equities in the first six months of the year and the subsequent, equally dramatic, correction highlighted the uncertainty surrounding China’s economy. Since the ‘Great Recession’ China has been a key engine of growth for many of the world’s major companies. The growing realization that China’s economy is much weaker than the officially announced growth rates indicate and, more importantly, that the government does not have sufficient control over the economy to underwrite the desired growth rate through fiscal or monetary policy has greatly increased uncertainty about growth in Asia and many Emerging Markets.

Third, a weaker China alone would have been enough of a deterioration in demand to cause commodity prices to fall. But the situation has been exacerbated by a massive supply expansion fueled by excessively accommodative monetary policy. That policy lowered the cost of funding and propped up prices, which led to a massive misallocation of capital. The inevitable correction has led to dramatic currency depreciation among many commodity producers in the Emerging Markets. Neither commodity prices nor currencies have bottomed, leaving much of the Emerging Markets in a deep bear market.